You may be thinking that this is not an issue you need to worry about as you have no plans to sell your agency. While that certainly may be true today, there just may come a point where selling your agency is more of a viable option. Maybe you got an offer that you just can’t refuse or possibly, one of your kids (that you were hoping would come into the agency), has decided to pursue some other occupation.
Without a doubt, M&A activity is extremely active. According to OPTIS Partners (an investment banking and financial consulting firm providing expert services to the insurance distribution industry), mergers and acquisitions of insurance agencies broke all records in 2017. In total, in 2017, there were 604 deals in the US and Canada, a 31% jump from 2016.
For the agencies looking to sell, there is a key issue that needs to be extensively considered. Most claims-made policies refer to this provision as an “Extended Reporting Period”. For many years, it has also been called “tail coverage”. This coverage allows an insured to report claims that are made against the agency after a policy has expired or been canceled with the condition that the wrongful act that gave rise to the claim took place during the expired/canceled policy.
I have seen many agencies (when they are selling) buy a 1 or 2-year tail. From my standpoint, they are leaving themselves severely vulnerable to claims that are made after the 1 or 2-year period has expired. I recently saw a study done by one of the foremost E&O carriers looking at the lag time between the date of the underlying loss and the date that the E&O claim was made against the agency.
If one were to buy a one-year tail, this would have covered about 44% of the claims. Buying a two-year tail would have increased this to just short of 70% of the claims. Having approximately 70% of the claims covered would have also meant that 30% of the claims would not have been covered. Sounds risky to me. Even stretchy this out to a 5-year tail would still result in 5% of the claims not being covered.
As you would imagine, there is a cost to buying a tail (there are many other factors as well that should be carefully reviewed). The premium for the tail is typically a factor of the last full annual premium. For a 3-year tail, the factor is 130% (this is the common percentage but not all E&O policies are consistent in this area). So, for an agency that has an annual premium of $20,000, a 3-year tail would cost $26,000. Not a small chunk of change but remember this is for 3 years of tail coverage. A 5-year tail would run around $38,000.
Many E&O carriers also offer a 10-year tail. This premium would be $40,000; an additional $2,000 to go from a 5-year tail to a 10-year tail. This would now provide coverage for over 99% of the claims, based on this E&O carrier’s study.
For agencies looking to sell, they should do their homework and factor in to the cost of the sale, the premium for the “tail coverage”. The decision on the length of the “tail” may just determine how comfortable you are in enjoying your retirement.